Buy to Cover: Everything You Need to Know

Investors purchase shares to cover short holdings. With the help of their brokers, they start buy-to-cover orders. An investor's short position is covered by a buy-to-cover order, which directs a broker to purchase the correct number of borrowed stock shares.

Intro

The last stage of the short-selling investment strategy, which aims to gain from a negative market, is referred to as "buying to cover." Suppose an investor's analysis of a security or index is accurate. In that case, they can benefit by selling borrowed securities, usually stocks, if they predict the security or index will decrease. Purchasing securities to offset the cost of returning borrowed securities is called purchasing to cover. A short sale and buying to cover are the most straightforward investing methods. However, there are other sorts as well. But it is not without peril. What you need to know about this strategy is as follows.

By shorting a stock, you can make money when its value declines. Short selling basically entails borrowing shares from a broker and selling them on the open market.

Selling the stock you purchased to close your investment is straightforward. A short position requires a little more work to close. A borrowed share must be returned to the broker to close a short position.

It calls for the stock short seller to purchase shares on the investor's behalf, ideally at a discount from the price at which the shares were borrowed. Short covering, also known as buying to cover, is the process of purchasing shares on the open market to close off a short position.

What Is Buy to Cover?

To close out short positions, investors purchase shares. With the help of their brokers, they start buy-to-cover orders. A buy-to-cover order asks a broker to acquire exactly enough borrowed stock shares to close out the investor's short position.

Purchasing a stock is not the same as purchasing a position to cover. An investor submits a standard buy order when they intend to buy and hold a particular stock. On the other hand, a buy-to-cover order aims to cover a short position. When a transaction is complete, an investor buying to cover does not own the stock because the investor had borrowed shares that had to be returned.

An investor that shorts a stock can place a buy-to-cover limit order designed to profit from price drops by defining a maximum target price at which the transaction can be carried out. An investor who shorts a firm while trading for $50 will benefit by $10 per share if the stock price ever drops below $40 thanks to buy-to-cover limit order with a $40 limit.

An investor who shorts a stock makes money if the price drops, as opposed to an investor who buys a stock and then sells it for a profit. Investors buying to cover are locking profits or losses from the short selling of stock.

You accumulate debt every time you make a transaction. Usually, we don't give it much thought.

You owe the restaurant money if you order a steak there. You owe the bar money if you order a beverage there.

Have your pals ever "covered" you while you went out with them?

We refer to our loans as "cover" in this context. Sometimes we act in a certain way without even realizing it.

The same holds for shorting stocks. Selling short is borrowing. You are paying off the loan when you purchase the shares to return them to your broker.

To cover implies to safeguard or protect. A liability is a debt. By purchasing coverage, you are insulating yourself from that liability. The phrase "purchase to cover" refers to this.

What Is the Relationship Between Buying to Cover and Short Selling?

You've probably heard the adage "buy low, sell high." Some people prefer to buy first and then sell. When they do, it is referred to as a short sale.

Consider your transactions as coins. On a coin, there are two sides: heads and tails.

In order to close your position after buying, you must sell. On the other hand, if you short sell, you must buy in order to close your position.

What Is a Short Sale?

A short sale is an investment that makes money when its value declines. Although this post will mention equities for the sake of simplicity, short positions can be taken with a wide variety of investments.

An investor borrows stocks from another investment to complete a short sale (typically a broker). They liquidate the stocks and deposit the proceeds into their account. The short position is now open. The position then remains open until the borrowed shares are returned.

Because you start it by selling equities that you do not yet own, it is known as a short sale.

When you purchase shares by borrowing them from your broker, this is known as a short sale. Going long is the antithesis of this. Before you purchase, you sell.

Want to learn more about short selling?

You don't actually own the shares since you borrow them. When you sell them, you assume a bad attitude.

Additionally, it would be best to give your broker back the shares. You buy them to do this. It's referred to as buying to cover.

A short sale is an investment that makes money when its value declines. Although this post will just mention equities for simplicity, short positions can be taken with a wide variety of investments.

An investor borrows stocks from another investment to complete a short sale (typically a broker). They liquidate the stocks and deposit the proceeds into their account. The short position is now open. The position then remains open until the borrowed shares are returned.

Because you start it by selling equities that you do not yet own, it is known as a short sale.

How Do You Close a Short Sale?

You purchase the exact number of shares that you borrowed when you're ready to finish your short sale. 

Find out if you can purchase or if you need to buy to cover by speaking with your broker or practicing on your platform. Some brokers, as I mentioned, only offer the "purchase" option. Others provide "purchase to cover" as a choice.

An investor purchases the same number of originally borrowed shares to cover a short sale position. Since the investor has purchased shares to replace those that were initially borrowed, this practice is known as "buying to cover."

After that, the investor returns the shares to the person who had lent them the original equities. The short position is finished as a result.

The trader will profit if the stock falls in value while the short position is active: The investor will take out a loan against the shares, sell them, and then repurchase them at a discount. The short position will become unprofitable if the stock rose in value while it was open: The cost of purchasing the equities back after the investor sells them will be higher.

Real-Life Example of Buying to Cover

The extraordinary share price increase of video game retailer GameStop was one of the major stock market stories of 2021. The future of GameStop, a troubled business that has been battling for years, is highly uncertain. Investors who anticipated a decrease in GameStop's stock price shorted the stock by obtaining shares from their brokers and reselling them.

Early in 2021, speculators stoked interest in the stock, which drove the stock's price sharply higher. Several investors who had shorted GameStop stock hurried to buy shares to cover their short positions out of fear of more losses as the stock's price rose.

The GameStop issue is noteworthy because a short squeeze took place when many investors raced to buy to cover their short holdings. Demand for the Company's shares increased due to an increase in purchasing to cover, outpacing the supply on the open market. As a result, the share price increased further, sending panic among short sellers scrambling to purchase to cover their shorts over the roof.

The majority of investors never decide to short a Company. Thus they never have a buy-to-cover necessity. However, it's critical to comprehend how purchasing covers functions if you find the idea of shorting a Company attractive.

Richard wants to purchase ABC Corp. stock for a short sell. A successful short sale would resemble the following:

• Richard requests a loan from his broker for 1,000 shares of ABC Corp.

• He makes $20,000 by selling these shares on the open market for $20 each.

• The share price of ABC Corp. then drops to $15.

• Richard spends $15,000 to purchase 1,000 shares of ABC Corp. at the discounted price. He is making this purchase to cover his position.

• He gives his broker the 1,000 shares of ABC Corp. back.

  
  

Richard made $5,000 off the entire transaction by selling the shares for more than it cost him to repurchase them.

An unsuccessful short sale would resemble this:

• Richard requests a loan from his broker for 1,000 shares of ABC Corp.

• He makes $20,000 by selling these shares on the open market for $20 each.

• Following that, ABC Corp.'s share price rises to $25.

• Richard spends $25,000 to purchase 1,000 shares of ABC Corp. He is making this purchase to cover his position.

• He gives his broker the shares of ABC Corp. back.

•  Although Richard profited $20,000 from the initial sale, the cost of repurchasing the shares to close out his position was higher. Throughout the deal, he loses $5,000.

Benefits of Buying to Cover

Hey, the best part of any deal is the chance to make money.

You cannot profit from your short sale without purchasing to offset the shortfall. And you are unable to leave without purchasing.

It would be best to buy to cover whether you are stopping out or making a profit. Whether a trade is closed on the winning or losing side, there is a certain amount of relief.

Being in a trade involves some kind of tension, whether it is exhilaration or trepidation. The weight is released after your position is closed. The ambiguity becomes clear. You can proceed.

•  A financial advisor can aid your risk management in your portfolio by using options and other strategies. Finding the ideal financial advisor who meets your demands is not challenging. You can compare up to three local financial advisors using SmartAsset's free service and select the one that is best for you. Start today if you're prepared to do so.

• Purchasing put options is another strategy to employ during a bad market. It is dangerous, just like short selling, but it can also lead to significant gains. When investing in the stock market, pay attention to taxes whether you're short selling or purchasing put options. The capital gains tax calculator from SmartAsset illustrates how taxes affect your gains.

Risks of Buying to Cover

While carrying out that same transaction is not risky in and of itself, shorting a stock can be. Purchasing enough shares to close off a short position is known as buying to cover.

Since the stock's lowest reasonable price is zero, when you purchase it outright as an investor, The sum you spent for it is the maximum you might possibly lose. Conversely, if you sell a stock short, your potential losses are theoretically limitless because there is no upper price limit on stocks.

In the same way, since the lowest stock price is zero, there is little upside potential when shorting a stock. While a $50 stock you own can increase in value by considerably more than $50, the maximum profit you can make from a $50 stock is only $50. The potential gain on a stock is limitless, but only if you own it.

In the market, short sales serve a variety of essential functions. Investors that seek to protect their portfolio in case of loss frequently utilize short positions. Investors can lower risk by taking an intelligent short position. To create a profitable investment in case something causes their entire portfolio to lose value, an investor can, for instance, purchase shares of specific tech businesses while selling short the entire industry. (However, the price of this risk avoidance is that when their core investments succeed, their short position loses money.)

It's crucial to realize that trading a short position entails far higher risk than trading a long position (in which you buy stocks and profit off their increased value). Your risk is constrained in an extended position by the stock's acquisition price. More than your initial investment can never be lost. After making your purchase, you wait to see what gains you will receive.

Your risk is not known when you are short of a position. You don't bet any money because you have no upfront expenditures other than broker fees. The stock's price instead determines your losses after the fact. If you have to repurchase the stock to close off your position after a losing trade, you will be actively losing money. Furthermore, it is impossible to predict how much money you will lose. In theory, losses could hypothetically be uncapped as the stock price rose indefinitely.

Purchasing to cover is identical to placing a regular buy order. When several people buy at once, there is an increase in demand. That can reduce your earnings. Even worse.

When numerous short sellers stop at once, it creates a "short squeeze." Each is attempting to buy to close their holdings. Increased demand drives price growth.

We retail dealers are now little fish in a vast ocean. It's the most turbulent market I've ever seen. This "Volatility Survival Guide" was created by my friend Timothy Sykes.

Due to all of this volatility, our position sizes will most likely not significantly impact the stock's price. However, the cost may alter quickly if everyone is heading in the same direction.

Getting the price you want can be challenging due to rapid price changes.

The Bottom Line

When a trader buys stocks to replace those that were borrowed when initiating a short position, the process is known as buying to cover or short covering. If the stocks have fallen in value while the trade was open, it yields a profit. It is how you close out a short position. Risk in a short position differs from risk in a long position in terms of both type and degree.

Short selling involves borrowing shares from your broker and offering them for sale at a loss. You are assuming a loss when you start a short transaction. Keep in mind that implies you'll be taking on debt. To buy to cover is to pay off that debt and end your position.

Too many inexperienced traders give the impression that shorting is simple, yet the risks can be extremely high. You are trading against yourself whether you are taking profits or minimizing losses.